Joe Raedle
Investment Thesis
Nike (NYSE:NKE) released its earnings recently and while the numbers weren’t great, they were still pleasantly surprising, especially in China where everyone expected the company to suffer badly. In this article, I argue that despite the resilience shown by the company during what was a tough quarter, the macroeconomic headwinds are likely going to overpower this resilience in the coming months. Having said that, from a valuation standpoint, the stock appears to be undervalued especially after the heavy selloff witnessed recently.
Nike Digital Continues to Deliver Even in a Tough Macro Environment
One of the few bright spots from Nike’s Q4 earnings results was the growth seen in its direct-to-consumer segment, Nike Direct. Revenues in this segment jumped 7% YoY and were up 11% YoY on a currency-neutral basis. This jump can be attributed to the surge seen in its digital business, Nike Digital, which continued its impressive growth. Q4 revenues for Nike Digital grew 18% YoY and the segment now represents 24% of the total brand revenue. Nike Digital also saw sales growing at low single-digits in China despite the country’s stringent COVID lockdowns, thereby underlying its strategic importance to the company.
Nike Direct in general, and Nike Digital in particular, looks set to grow further as the company plans to give its Enterprise Resource Planning (ERP) system a makeover as part of the company’s consumer-direct acceleration strategy. The new ERP system is expected to go live in China later this month and is expected to be deployed in FY24 in North America. ERP tools are tasked with tracking and managing inventory, procurement, supply chain, and other core business operations. The fact that Nike is re-designing its ERP therefore, demonstrates the importance that the company places on its DTC segment, and rightly so.
According to Statista, the worldwide retail e-commerce sales is expected to grow from $4.93 trillion in 2021 to approximately $7.4 trillion by 2025, which translates to a growth of over 50% over the next four years. Nike Digital, therefore, is likely to remain a growth catalyst for the long-term.
Nike’s other digital initiative involving the Metaverse also showed progress in the quarter gone by. With the help of RTFKT, the digital fashion company that Nike acquired last year, the company launched its first NFT sneakers, the Nike Cryptokicks, modelled after the Nike Dunk sneakers. The sneakers, which cost anywhere between $6,000 and $10,000, is the company’s digital bet to further its Metaverse ambitions.
While the Metaverse is far from being mainstream, it is expected to be the next major battleground for retail. According to Market Data Centre, the retail market in the Metaverse is expected to be valued at over $125.7 billion by 2030, which represents a CAGR of approximately 36%. The early moves made by Nike, such as the Cryptokicks, makes the company well-positioned to capitalize on this lucrative opportunity in the coming years.
Macro Headwinds to Test Nike’s Resilience: The Risks Ahead
While Nike displayed its resilience in Q4 despite the multitude of headwinds that it faced, continuing to rely on its resilience in the coming quarters might be too much to ask for. There are plenty of landmines, set by the current macro environment, which the company has to navigate.
For starters, transit times continued to remain elevated compared to pre-pandemic levels and are expected to stay elevated in FY23, which could lead to higher shipping costs and an increased probability of obsolete inventory. Management has already indicated that the company faces a 100 bps headwind in Q1 thanks to elevated ocean freight costs and higher product costs. Gross margin pressure is expected to exceed 100 bps, according to the management, as a result of inventory arriving late, which subsequently causes the company to spend more on promotional activity in order to clear out the now-obsolete inventory.
Secondly, although Nike Digital is witnessing tremendous growth, it comes at a great price. SG&A expenses increased 8% in Q4 on account of investments in strategic technologies, thereby increasing the company’s Direct Variable Costs. As the company starts to place greater emphasis on Digital Sales, expect the company to invest even more towards this initiative, especially in China. In the current environment, where inflation remains elevated and the threat of a recession looms large, spending big is the last thing any company wants. But the company has no choice and as such, these higher investments are expected to be a major drag on the company’s bottom-line in the short-to-medium term.
Finally, the company’s problems in China continue to cause a headache. The company was already facing issues in the region, and these issues have now exacerbated thanks to the country’s stringent COVID lockdowns. The company already expects revenue growth to slow down in Q1 of FY23 as it attempts its turnaround in China. Revenues and operating margins declined 20% and 55% respectively in Q4. Although Nike Digital provided some relief, it’s going to take some time before the Company can find its feet in one of its biggest markets.
Valuation
| Target Price | $125.33 |
| Item | FY23 Projections |
| Sales |
$49 billion (5% growth YoY) |
| Gross Margins |
45.5% (50 bps decline) |
| Projected Gross Profit for FY23 | $22.3 billion |
| SG&A Expenses |
$15.98 billion (8% growth YoY) |
| Tax Rate | 15% |
| Projected Net Income | $5.37 billion |
| Number of Shares Outstanding | 1.6 billion |
| Projected EPS | $3.36 |
| Historical Forward P/E | 37.3x |
Source: Author’s projections and Company’s Q4 Press Release
The company expects revenues to be flat to grow low double digits on a currency-neutral basis. I therefore assume revenues to be 5% (mid-point of company estimates), which translates to FY23 revenues of $49 billion.
Gross margins are expected to be flat to declining by 50 bps. Given the headwinds that the company faces in the current climate and the issues plaguing the company in China, I project gross margins to decline by 50 bps, which translates to FY23 gross margins of 45.5%.
The company’s SG&A is expected to increase high single digits to low double digits. I assume these expenses to increase by 8%, in line with the FY22 growth number, which results in an SG&A of $15.98 billion.
The tax rate is expected to be mid-teens, so I assume it to be 15%. Thus, FY23 net income is projected to come in at $5.37 billion.
According to Refinitiv, the number of shares outstanding to calculate the diluted EPS is 1.6 billion. That would give a diluted EPS of $3.36. The company’s historical forward P/E is 37.3x.
This results in a price target of $125.33, which implies an upside of 16% to the closing price on 07th July 2022.
Concluding Thoughts
Nike’s stock has been battered due to both the current macro environment and the continued headwinds it faces from one of its most important markets, China.
These challenges appear to be far from over. Elevated shipping costs, the higher investments required to grow its digital business, and the massive rebuilding job it has on its hands in China are all significant headwinds facing the company in the short-to-medium term.
From a valuation standpoint, the stock does appear to be undervalued and the current levels look like a good place to initiate a position for the long term. Moreover, the tremendous growth potential in its Digital Business together with the moves the company is making towards achieving its Metaverse ambitions are proof that the company’s future is secure.
In the near term however, expect more pain as the current macro climate really puts the company’s resilience to test.
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